The Great Indian Fraud: Serious Frauds Which Shook the Economy

By Smarak Swain

How do tax havens and syndicates running shell companies help fraudsters escape the long arm of the law?
How does the ambiguity of valuation in the start-up ecosystem increase its vulnerability to corporate fraud?
How are manufacturers and exporters from China exploiting India's Free Trade Area (FTA) with other countries to dump goods at artificially low prices in the Indian market?
What challenges does the Belt and Road Initiative (BRI) of China pose for regulators of India?
Why do people fall for Ponzi and pyramid schemes again and again?

Serious frauds affect society and economy in damaging ways, belittling the common man's trust in the system. Yet, barely do we understand how these affect our lives. A first-of-its-kind, The Great Indian Fraud reveals how all such frauds result from the manipulation of complex financial transactions, involving simple mathematics and tricks, to deceive regulators, enforcers, business partners and customers.
Drawing on his experience in the fields of forensic audit and financial investigation, author Smarak Swain explains the modus operandi behind some of the most notorious cases of fraud-Haridas Mundhra, Jayanti Dharma Teja, Harshad Mehta, Ketan Parekh, Hasan Ali Khan, B. Ramalinga Raju, Nirav Modi, Vijay Mallya, Nirmal Singh Bhangoo and many more-narrating the rise and fall of the greatest fraudsters of our times.

Informative and skilfully narrated, The Great Indian Fraud is a must-read to understand how frauds happen, how law enforcement agencies handle crises, the sectors that witness maximum frauds as well as the emerging sectors that are at high risk.

• Language: English
• Publisher: Bloomsbury Publishing
• Release date: Dec 28, 2020
• ISBN: 9789389867244

Book preview

PROLOGUE

Serious frauds are a result of failures that challenge free markets and disrupt economic processes in ways more profound than the fraud itself. Such fraudulent acts create ripples that undermine the economic security of liberal democracies like India.

The free market economy is based on the idea that when individuals are left to themselves, they take decisions in self-interest that automatically leads to order. Order comes from uncoordinated behaviour of individuals, almost like a miracle. Economist Adam Smith, who introduced us to this miracle in 1759, described it as an ‘invisible hand’ of the market. Smith said by pursuing self-interest, an individual ‘frequently promotes that of the society more effectually than when he really intends to promote it’.¹

Austrian-British economist Friedrich Hayek saw the invisible hand of the market as a spontaneous order, which comes in a free market and results in better allocation of resources, than any planning could achieve. It is now widely accepted that an ideal free market economy, where every individual is free to act selfishly, is much more efficient than any alternative system in which the State intervenes. The State has no role in a free market economy.

However, an ideal market is possible only when every market participant follows the rules and does not game the system. When participants try to game the market, ‘market failure’ happens. Free markets yield poor outcomes whenever market failure happens. This is where the State plays a role: preventing and curing market failure.

Market failures are broadly of four types: Externalities, asymmetric information, market power and public goods.² Financial frauds are a form of market failure through ‘asymmetric information’ and may be the severest of all forms of market failure. The 2008 sub-prime mortgage crisis in the US, which became a worldwide economic crisis, is often quoted by critics of the free market system to prophesize that free market economics has failed. The sub-prime crisis was the result of financial frauds perpetrated at multiple levels. Banks and other lending institutions aggressively gave home loans to individuals with sub-prime credit rating at prime lending rates. This was brokered by mortgage intermediaries, who were eager to get more and more customers so that they could get brokerage. Banks, in turn, securitised these sub-prime loans by declaring them as prime loans. Investment banks misrepresented the characteristics of these securities and sold them to institutional investors. When homebuyers defaulted on their loans en masse, the securities turned stale and afflicted the entire chain. There was fraud committed at multiple levels.

Financial frauds are cheat codes that can undermine a free market economy. Small and stray frauds such as credit card fraud or phishing affect some people, but serious frauds in the financial system of an economy affect the entire economy. First, it affects the level of trust people have in the market. In a way, serious frauds can be equated to epidemics and pandemics. After the COVID-19 pandemic, workers and managers went into a lockdown mode. There was widespread fear in the market and the global economy came to a near standstill. COVID-19 infected a number of people, but the fear of contracting it affected economic behaviour of many more. Similarly, whenever a serious fraud hits the news, people lose their confidence on the entire market. The market’s integrity is questioned.

Critics jump in and cry foul. They write away the free market economy and call for more government interference and control. Many a time, serious frauds generate public opinion against keeping the market free. Instead of demanding laws against market failure, they demand laws against the free market itself.

A second consequence is that it undermines the level of trust within the market. Individual and institutional investors withdraw their investments from the market, thus affecting the market’s efficiency. The call for greater regulation translates into reactive rules that require more stringent documentation and due diligence. This, too, affects the market’s efficiency.

A third consequence, which happens in the case of widely-prevalent frauds, is economic rupture.

Hence, preventing serious frauds is one of the prime responsibilities of the government that believes in free market economy. Ironically, given the complexity of the financial world of our times, it is very difficult for any State or regulator to prevent financial frauds.

What Are Serious Frauds

This book seeks to profile serious frauds, their modus operandi and their impact on economic institutions. The book goes on to show that the modus operandi followed in serious frauds are derived from elementary mathematics and logic. Modus operandi of most serious frauds we have read about in recent years are similar to the ones detected decades ago. That indicates, the modus operandi of serious frauds has not actually changed over time. The complexity of the system has changed, which has helped serious frauds to recur and perpetuate the system.

A few definitions are warranted to put terms, used in this book, in perspective. Economic crime or white-collar crime includes any kind of criminal behaviour or infringement that leads to unlawful economic advantage to the person committing it. It is a broad definition that includes many financial and non-financial crimes. Financial crimes are a subset of economic crimes that include tax crimes, corruption, terror financing, money laundering, etc.

‘Fraud’, itself being a generic word, is often used to describe financial as well as some non-financial crimes. For instance, elaborate schemes to fool the taxman are also referred to as tax fraud. However, the phrase ‘financial fraud’ has a specific definition in relation to the market. For the purpose of this book, financial fraud is defined as ‘acts and statements through which financial market participants misinform or mislead other participants in the market by deliberately or recklessly providing them with false, incomplete or manipulative information related to financial goods, services or investment opportunities’³ in a way that violates the law.

A serious fraud needs to be understood by its colloquial meaning. It is a financial fraud of enormous proportions. There are some exceptions though. Some serious frauds are not financial frauds. For instance, the Comptroller and Auditor General (CAG) of India and the CBI have, at various times, levelled allegations of corruption in procurements and resource allocation that involve malfeasance of billions, even trillions, of rupees. However, such scams do not directly affect the economy, although they directly affect government finances. It is a different story for another time.

Serious frauds discussed in this book are large financial frauds that harm the economy. And then again, not all financial frauds take the form of serious frauds. Only those financial frauds that can trigger a vicious cycle of fraud, siphoning and profiteering, become serious frauds. Such frauds grow in size in each cycle and manage to take on such gigantic form that they instill trust and confidence in people. It is only when the bubble bursts that people get to know the reality. However, by then, the fraud would have been committed and the money siphoned off.

The bubble usually bursts when a gatekeeper is not impressed by the halo of success created by the fraudsters. Gatekeepers are intermediaries who are supposed to provide necessary checks and balances, including independent directors, external auditors, attorneys, credit rating agencies and regulators such as the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI).

There is a general consensus among scholars that financial frauds are linked to economic cycles.⁴ In its April 2020 issue, The Economist observed that booms ‘help fraudsters paper over cracks in their accounts, from fictitious investment returns to exaggerated sales. Slowdowns rip the covering off’.⁵ It claimed that many big book-cooking scandals of the past 20 years emerged during economic downturns. As star investor Warren Buffett once said: ‘You only find out who is swimming naked when the tide goes out.’⁶ Economic crises lead to a general credit crunch, which strains fraudulent schemes. Many of them fall apart as a consequence. An economic crisis also instills pessimism and caution in the heart of auditors and creditors and they start asking hard questions, which they otherwise would not. This, of course, helps detect frauds.

While downturns expose frauds, fraudsters gnaw at the market at all times and have become quite pervasive in recent times. Frauds in financial statement, for example, often occur.⁷ The line between creative accounting and accounting fraud has always been blurred, but the frequency of accounting scandals has been so high in recent years that they are now often seen as being hidden in the nook and cranny of corporate life.⁸ In a global banking fraud survey conducted by KPMG in 2019, more than 50 per cent of respondents globally said they experienced an increase in fraud value.⁹ Investment scams, such as ponzi schemes, have become so rampant that they ‘seem to have reached the proportion of an epidemic’.¹⁰ A study conducted by the Canadian Securities Administration in 2007, found that one in twenty Canadians were victims of investment frauds.¹¹

Why are there so many global financial frauds? This is a question we shall be asking time and again in this book. At an elementary level, every fraud is a problem of control. Wherever control fails, fraudsters abuse the loophole, but the problem of recurring financial frauds is more than just a problem of control. Every serious fraud is dealt with by tightening norms and disclosure requirements. And yet, financial frauds recur. The reason behind this is the increasing complexity of financial transactions. New technologies, coupled with innovative financial tools, have introduced many a jargon in the world of finance and make it less comprehensible.¹² A wide array of financial instruments and legal structures are readily available to help the corporates structure their business in ways that hide liabilities and conceal sham transactions.

Take, for example, the case that most scholars studying accounting frauds consider an archetype–Enron. Enron used Special Purpose Vehicles (SPVs) to effect sophisticated off-balance sheet accounting to hide its rising debts, which helped it paint a better picture than the reality. It had set up more than 3,000 SPVs, of which 800 were based in tax havens. Tax havens provide a conducive ecosystem for fraudsters in the form of stringent banking secrecy laws and facilities to run shell companies while hiding their control over such companies.

Regulation fails repeatedly because the regulatory cycle–the time in which legal regulation catches up with a deviant innovation–is ruptured. Step 1 involves introduction of new technological and financial innovations. Rules to control abuse of such innovations are still not drafted. Scamsters smell new ways of committing fraud using these innovations. In Step 2, the scamsters commit the actual fraud. Regulators realise the misuse of new loopholes and try to bring new rules to institute control in Step 3. Then another innovation again takes us to Step 1 and the regulatory cycle continues. A healthy regulatory cycle is one where the time gap between Step 1 and Step 3 is low, maybe a couple of years. In recent years, we have seen situations where the regulatory cycle is ruptured. Regulators take years to detect frauds because of the increasing complexity of frauds. Innovations are being introduced at break-neck pace. Step 2 runs for extended periods. By the time regulators plug a loophole in the cycle, a new innovation would have already started a new cycle.

FIGURE 1: The Regulatory Cycle

Source: Author

This book seeks to simplify questionable schemes of our times that appear incomprehensible. There are only a handful of modus operandi that lead to serious frauds and they are derived from basic mathematics and logic. The age-old modus is being operated behind veils of complex corporate structures and exotic financial instruments. The first chapter on Bank Frauds narrates the incredible story of how fraudulent loans are taken and then siphoned off. Fraudsters, who manage to set up a vicious cycle of availing loans, perpetuate the biggest frauds against lending institutions. The second chapter gives an overview of unfair trade practices in the stock market and talks about how some of these securities frauds assume serious proportions by perpetuating vicious cycles. Chapter three shows how mispricing in international trade is used to rotate funds and commit EXIM frauds. Other interesting modus operandi, involving GST frauds and circumvention of anti-dumping duties, are also discussed in this chapter. The fourth chapter discusses a few of the many types of corporate frauds that involve creative accounting practices.

Creative accounting and manipulative bookkeeping are core to the cases discussed in the first four chapters. The fifth chapter discusses pyramid and ponzi schemes that are closer to the ordinary meaning of swindling.

Chapter six discusses shell companies, mailbox companies and secrecy jurisdictions that facilitate and catalyse fraudulent acts. In a way, they constitute a favourable ecosystem that fraudsters utilise and rely on.

A disclaimer on the narrative is due at this time. At times, the book talks to the reader when explaining modus operandi, which the reader may mistake for a how-to-commit-fraud guide. The author considers himself a crusader against serious frauds and at no time intends to educate the reader about how to commit frauds. The narration keeps shifting to enliven the chronicle. Portrayal of some of the greatest fraudsters of our time is adulatory, at times, and it is so because they are not just another hustler. They are financial wizards who used their intelligence to follow the wrong path. The author is reverential towards their ingenuity, not their conduct. Their conduct is clearly deplorable.

The book discusses many convicted fraudsters. It also discusses some live cases wherein law enforcement authorities have levelled serious allegations, but the matter has not yet reached a finality in judicial forums. In such cases, the author merely discusses the allegations levied by law enforcement agencies, without drawing any conclusion on culpability. The discussion is based on material available in the public domain and does not derive from any information that may have come to the author’s knowledge in the course of his discharge of official duties as investigator or assessor in the Income Tax department.

The views expressed by the author in this book are personal and do not reflect the opinion of the Government of India or the Income Tax department in any way.

1

The Perfect Bank Heist: Loan Fraud

The British royalty is known for its wealth and opulence. The magnificent Buckingham Palace, the London abode of the British royalty, is a fine example of this opulence. Each and every corner of this palace is intricately designed with the costliest of fixtures. The Royal Mews, that takes care of the road travel arrangements for the Queen and members of the Royal Family, boasts of a number of Rolls Royce, Jaguars and Bentleys as well as the finest horses in all of England. For special occasions at the Buckingham Palace, golden plates and antique golden cutlery are taken out for the royal guests. And just three miles from all this opulence and grandeur is Regent’s Park, where stands the mansion of another king, Dr Vijay Mallya. Mallya, the fugitive Indian liquor baron who is wanted on alleged fraud and money laundering charges, had controlling stakes in United Spirits Ltd and United Breweries Ltd. He was also the founder and owner of the now defunct Kingfisher Airlines. Known for his flamboyant lifestyle, Mallya was the self-proclaimed ‘King of Good Times’.

Mallya can not only match, but also exceed Queen Elizabeth’s penchant for extravagance. If the Queen sometimes eats out of gold plates, the King of Good Times often poops on a commode made out of gold.¹

It has been more than a decade since the global financial crisis of 2008, and yet India still remains plagued by cases of bank loan frauds. The fraud pulled off by Mallya is considered the most infamous of such cases. Mallya, the promoter of liquor-cum-fertiliser conglomerate United Breweries Holdings Limited (UB Group), entered the airline industry with Kingfisher Airlines in May 2005. Owing to a series of unwise business decisions, the airlines accumulated heavy losses by the end of 2011. By early 2012, half of its fleet was grounded, its employees were on strike for non-payment of salary and the Income Tax department had attached its bank accounts for not depositing tax deducted at source (TDS) from its employees’ salaries. The airline had to completely stop operations by October 2012.

By 2014, Kingfisher Airlines’ debts accounted for most of the non-performing assets (NPAs) of India’s public sector banks (PSBs). It is not that Mallya did not have the wherewithal to pay. In an acquisition deal that started in 2012, London-based multinational alcoholic beverage company, Diageo, bought majority shares in United Spirits Limited, a UB Group company, from Mallya. It paid Mallya ₹3,635 crore for his 19.3 per cent stake in United Spirits. Over the next few years, Diageo paid significant sums to various companies of the UB Group for acquiring majority stake in United Spirits. The deal went through despite Karnataka High Court’s instructions to Mallya not to alienate his shares in United Spirits. So, Mallya clearly had the means to pay back creditors of Kingfisher Airlines. It was his moral and legal duty to clear the debt. After all, he had given his personal guarantee for the loans and UB Group’s holding company had given a corporate guarantee.

Diageo made the payments to Mallya’s offshore accounts.² Since the company was headquartered in the UK and Mallya himself was a non-resident Indian, there was nothing much the Indian authorities could do to recover the defaulted loan. By the time India’s PSBs could take legal action for recovery of their loans, Mallya had escaped to the UK. He now shuttles between his English country estate and his mansion in Regent’s Park.

The kind of fraud that Mallya committed only begets other frauds of a similar nature. When a person escapes the long hands of law after committing a serious fraud, he tends to trigger similar proclivities in a whole generation of imposters and swindlers. In Mallya’s case, what’s worse is that he was already an icon for many. In his good times, he ruled over all that our mothers considered vice and we cherished in our teenage: wine, women and other worldly pleasures. He had his stud firm in Bengaluru, the Kingfisher calendar that featured models in exotic locations, a yacht, a Formula 1 racing team, a cricket team in the Indian Premier League and the sword of Tipu Sultan, which he had bought at an auction to remind everyone that he was indeed the emperor of good times.

Even when he escaped from India, he did so with elan. On 2 March 2016, he attended the Parliament, picked his then girlfriend, seven pieces of luggage, flashed his diplomatic passport at immigration and boarded a Jet Airways flight to London.

However, Mallya’s is not a typical case of loan fraud. Yes, he is a willful defaulter. It has been alleged that he has siphoned off funds from his firms through shell companies registered in tax havens. However, it cannot be denied that he was principally an entrepreneur who took up unwise and risky ventures. His case is unlike other loan frauds that surfaced in the decade starting 2009.

Trail of Loan Frauds

It, however, looks like Mallya’s bank default was not as big as many other loan frauds seen through the decade. His default was to the tune of ₹9,091 crore, including interest (as on November 30, 2015). Add to that the income tax and service tax of ₹1,215 crore that he owed. In comparison, the one allegedly perpetuated by Infrastructure Leasing & Financial Services Limited (IL&FS) involved a loan default of ₹90,000 crore. The Bhushan Steel case involved a loan default of ₹45,818 crore. These two cases dealt a huge structural jolt to their respective sectors as well as to the economy.

Brij Bhushan Singal, the patriarch of Bhushan Group, was a self-made man. He started by making hinges and fasteners for railway tracks in Chandigarh. Along with his sons Neeraj Singal and Sanjay Singal, he acquired an ailing steel factory in Sahibabad in 1987. That marked the quick rise of the Bhushan Group.³ The group split in 2011 after a family dispute. Brij Bhushan and Neeraj retained Bhushan Steel and Bhushan Energy, while Sanjay took control of a third company called Bhushan Power and Steel.

In 2005, Brij Bhushan and Neeraj started construction of an integrated steel plant in Odisha. Those were heady times for the steel industry in India. The demand from the automobile sector was robust. China had a huge import appetite due to the upcoming 2008 Summer Olympics in Beijing. However, the sector faced a slowdown after the Olympics. Steel prices peaked in 2008 at $1,265 per tonne and quickly fell to $300 per tonne by 2012.

Loans started piling up while the revenue sources tapered. Interestingly, Bhushan Steel managed to secure more loans even as the industry was experiencing a slowdown. Its long-term loans increased from ₹15,528 crore in March 2012 to ₹21,664 crore in March 2013. By March 2015, the company’s long-term loans swelled to ₹31,477 crore. Profits kept dwindling in this period and the company clocked a loss of ₹1,255 crore in 2014–15.

Signs of default were evident as early as August 2014, when the CBI alleged that Bhushan Steel had defaulted on a ₹100-crore loan repayment to Syndicate Bank, but bribed the bank chairman for a credit extension. Neeraj Singal was arrested on 7 August 2014, and later released on bail.

The key question here is: How did Bhushan Steel manage to raise so many loans from banks? The SFIO made a detailed forensic audit of its affairs in 2017, and filed a charge sheet subsequently. Their audit ‘revealed that… Brij Bhushan Singal and Neeraj Singal… used a web of 155 companies, which were directly or indirectly controlled by the Singals, to siphon off money from Bhushan Steel and Bhushan Energy’.⁴

The SFIO divided the companies into four categories due to the complexity of transactions involving shell companies. The four categories were: A, B, C and D. Category A consisted of Bhushan Steel and Bhushan Energy, the operating companies. Category B included 62 companies that were directly under the control of Brij Bhushan Singal and Neeraj Singal. The Singals were shareholders and directors in these companies. Category C consisted of 85 companies in which employees of Bhushan Steel were made directors from time to time. The SFIO alleged that while some of these companies provided manpower to Bhushan Steel, others were involved in fund diversion. Category D comprised eight companies that were run by entry operators. Entry operators are professional syndicates that operate shell companies and provide services for laundering of funds.

The SFIO alleged in the charge sheet that banks granted loans to Category A companies and these companies gave loan funds to Category B shell companies as advances. Funds were layered through Category B companies and supplied to Category C companies. Category C companies then gave the funds back to the promoters. The promoters used the funds to acquire assets. A part of the funds were infused back into Category A companies as promoters’ share. Such rotation of borrowed money ended up projecting loan funds as promoters’ contribution in the accounts. Banks inferred that if promoters were putting in more money on a project, they could also advance more money.

Between 2009–10 and